The Changing Face of the U.S. Grain System

Transcription

1 United States Department of Agriculture Economic Research Service Economic Research Report Number 35 The Changing Face of the U.S. Grain System Differentiation and Identity Preservation Trends Aziz Elbehri

2 Visit Our Website To Learn More! Want to learn more about grains and specialty crops? Visit our website at You can also find additional information about ERS publications, databases, and other products at our website. National Agricultural Library Cataloging Record: Elbehri, Aziz The changing face of the U.S. grain system : differentiation and identity preservation trends. (Economic research report (United States. Dept. of Agriculture. Economic Research Service) ; no. 35) 1. Grain trade United States. 2. Product differentiation Economic aspects United States. 3. Market segmentation United States Costs. 4. Specialty crops Economic aspects United States. 5. Agriculture and state United States. I. United States. Dept. of Agriculture. Economic Research Service. II. Title. HD9035 Photo credits: PhotoDisc and USDA Photo Center. The U.S. Department of Agriculture (USDA) prohibits discrimination in all its programs and activities on the basis of race, color, national origin, age, disability, and, where applicable, sex, marital status, familial status, parental status, religion, sexual orientation, genetic information, political beliefs, reprisal, or because all or a part of an individual's income is derived from any public assistance program. (Not all prohibited bases apply to all programs.) Persons with disabilities who require alternative means for communication of program information (Braille, large print, audiotape, etc.) should contact USDA's TARGET Center at (202) (voice and TDD). To file a complaint of discrimination write to USDA, Director, Office of Civil Rights, 1400 Independence Avenue, S.W., Washington, D.C or call (800) (voice) or (202) (TDD). USDA is an equal opportunity provider and employer.

3 United States Department of Agriculture Economic Research Report Number 35 February 2007 A Report from the Economic Research Service The Changing Face of the U.S. Grain System Differentiation and Identity Preservation Trends Aziz Elbehri Abstract This report examines current trends in the U.S. grain industry. Many identity preservation (IP) grain systems have emerged recently, driven by a confluence of supply and demand factors. IP grain requirements for specific production protocols, marketing channels, and quality assurance depend on whether the crops are trait-specific, non-gm (genetically modified), organic, or pharmaceutical. Cost structures vary according to the relative importance of segregation and risk management. High information management, greater market coordination, and frequent reliance on contracts characterize IP grains. IP grain markets are also inherently riskier, with volatile supply, inelastic demand, and fluctuating price premiums. Increasing grain differentiation is altering the marketing structure of the U.S. grain industry and creating possible roles for government policy, particularly in market facilitation, standard setting, and regulations affecting food safety and biosecurity. Keywords: Identity preservation, production differentiation, specialty grain, segregation cost, traceability, quality assurance, grain attributes, risk management, information management Acknowledgments The author gratefully acknowledges the contributions of Cullen Hawes, student intern at ERS in summer 2003, and Linwood Hoffman, William Chambers, Cathy Greene, Gerald Plato, and William Lin, ERS. Special thanks to Demcey Johnson, ERS, for managerial leadership and guidance on the project. Thanks also for very helpful reviews to Michael Boland, Kansas State University; Corinne Alexander, Purdue University; James Pritchett, Colorado State University; Warren Preston, USDA-AMS; Peter Goldsmith, University of Illinois Urbana-Champaign; David Skully, John Dunmore, and Barry Krissoff, ERS. And finally, thanks to Dale Simms and Wynnice Pointer-Napper (USDA, ERS) for editorial and design assistance. NOTE: The use of brand or firm names in this publication does not imply endorsement by the U.S. Department of Agriculture.

4 Contents Summary iii Introduction and Overview Marketing Channels and Quality Assurance Production Requirements and Marketing Channels Quality Assurance E-Commerce and Third-Party Services Costs of Segregation Sources of Segregation Costs Variation in Cost Factors Risk Management Risks Associated With Trait-Specific Crops Risks Specific to Non-GM and Organic Crops Risks Associated with Pharmaceutical and Industrial Crops Information Intensity and Market Coordination Information Intensity Market Coordination: Role of Contracting Effect of Contracting on Price Risk and Risk Sharing Price and Market Dynamics The Role of Government in Differentiated Grain Markets Conclusions References Recommended citation format for this publication: Elbehri, Aziz. The Changing Face of the U.S. Grain System: Differentiation and Identity Preservation Trends, ERR-35. U.S. Dept. of Agr., Econ. Res. Serv. Feb ii

5 Summary The U.S. grain system is increasingly marked by product differentiation and market segmentation. More specialty crops now require either some form of segregation or full-scale identity preservation to keep them separate from conventional commodities. Market segmentation within the grain system is driven by the need to preserve its market value, or ensure purity of the product. Internationally, U.S. grain markets must increasingly conform to a new regulatory environment reliant on traceability and identity preservation. What Is the Issue? Differentiated grain markets differ markedly from those for commodity grains. The commodity market is characterized by minimum common standards, a large number of buyers and sellers, and high flexibility. Price is the primary coordination mechanism, with commodity exchanges often the locus of price discovery. Pricing is with reference to standard grades (e.g., number 2 yellow corn) that are broadly accepted, enhancing market fluidity. By contrast, differentiated grain markets have fewer buyers and sellers, higher costs for segregation or full-scale identity preservation, and specific quality standards, compounded by higher risks in production and marketing. Differentiated grains usually command price premiums, based on the extra costs incurred by producers and shippers and willingness to pay at the processing or retail level. This report examines the economics of grain differentiation, including the cost implications of different protocols, the unique risk factors of adopting IP (identity preservation) grains, the use of contracts, and the role of government as a provider of market information and facilitator of product-differentiated markets. What Did We Find? To preserve the identity of a specialty crop, segregation from commodity grains or oilseeds is required. In some cases, this is necessary to protect purity and to preserve the value of the specialty crop. In other cases, the goal is to prevent contamination through accidental commingling (for example, biotech or not), or to protect products that are approved only for certain uses (for example, industrial use only). The cost structure for IP grains differs with the degree of segregation and/or IP required. For high-value grains, costs encompass both segregation and identity preservation in the supply chain, and the costs to mitigate risks specific to IP grain markets. Volume shipped, shipping method, tolerance levels, testing, and documentation requirements can influence segregation costs. Costs associated with risk mitigation depend on the type of specialty crop as well as the purity level. Lack of compliance with a product specification can lead either to a price discount or rejection of a shipment by buyers. Price setting under an IP grain system is characterized by premiums or discounts relative to standard commodities, whether or not production and marketing is under contract. Premiums are affected by various factors, including the proximity of suppliers to buyers and the cost and availability of iii

6 substitutes. For many trait-specific crops, price premiums rise or fall depending on supply conditions for the generic commodity. Differentiated grains require more coordination between growers and handlers or processors, and more sharing of information. This arises from the traitspecific quality attributes of IP grains: within the supply chain, information must be conveyed about raw materials, key ingredients, and production/manufacturing processes. Assurance of product quality and authentication of process/product claims is often required. Farm product suppliers (for example, seed producers) must demonstrate that product attributes are verifiable and show supporting documentation. Production contracts are important for trait-specific grain to ensure that the attribute-specific commodity is delivered and that predetermined management practices are used. For the producer, contracts can ensure a return adequate to cover costs of identity preservation and any yield drag associated with trait-specific varieties. Contracts can also ensure that there is a market for a niche product. Production and marketing of trait-specific grains involves risks associated with price, quality, and information. Testing and documentation bring greater transparency to the transactions (in terms of quality and production processes), but the loss of anonymity also exposes producers and handlers to new risks. Farmers management ability can affect both yield performance and proficiency with contracts and relationships. On the buyer side, contracts help meet the demand for specific product qualities, improve cost efficiencies of product processing, and reduce transaction costs. Risks are typically higher for specialty crops than for generic crops. Non-GM crops subjected to testing run the risk of rejection. Organic grain can be accidentally contaminated. Pharmaceutical crops are not licensed for food/feed use, so risk of contact with the food supply can make their handling far more costly. Sophisticated risk management practices are required to minimize the chance of potential gene outflow. This entails a closed-loop system with rigorous quality control and a tight chain of custody. Increasing grain differentiation in the U.S. food and feed industry may put new demands on government, but it is not clear whether USDA s traditional roles in commodity markets should be extended to specialty grains. The collecting of price information for commodities is not easily extended to specialty grains, which are heterogeneous, small in scale, and locally concentrated. Moreover, price information can be proprietary, established through private supplier-buyer contracts. Likewise, USDA-approved grades for specialty grains may not be justified since desired traits are idiosyncratic. As differentiated grain markets expand, the U.S. grain industry faces new demands for identity preservation, segregation, and product tracing. This will require adaptations in grain production and handling, closer market coordination, more extensive information systems, new risk management tools, a better understanding of costs, and more third-party services for auditing, verification, and quality assurance. iv

7 How Was the Project Conducted? The project was based on an extensive analysis of the literature covering industry case studies, academic research, and government documents. Key findings especially those relating to farm risk management, cost of segregation, and IP market dynamics are drawn directly from analyses conducted at the Economic Research Service with outside collaborators. v

8 The Changing Face of the U.S. Grain System Differentiation and Identity Preservation Trends Aziz Elbehri Introduction and Overview The U.S. grain system is undergoing increased product differentiation and market segmentation (fig. 1). Over many decades, the production and marketing of corn and soybeans have reflected their relative homogeneity as bulk commodities used mostly for feed. While specialty crops (high-oil corn, food-grade soybeans) have long coexisted with commodities, industrial processing for the most part did not require segregation of varieties, while breeding favored input features or yield over output traits. Infrastructure and marketing were mostly in keeping with bulk-type products. However, a number of forces including biotechnology, industrial processing innovations, logistical advances, information and measurement technologies, and consumer preferences have induced rapid market adjustments, creating more opportunities for differentiation and for the development of products with specific traits as farmers sought to diversify outside the commodity system. As markets responded to these economic incentives, cost-effective approaches to market segregation and identity preservation Figure 1 Grain differentation trends and grain market characteristics Before Now Commodity Commodity? < Biotechnology < Food processing < Logistics < E-commerce < Consumers < Globalization Future trends? Commodity Large volumes Low cost Minimal quality standards Purchaser flexibility Thin Geographic concentration Higher inherent risk Information-intensive 1

9 (IP) were implemented to meet the demand for trait-specific specialty grains and to capture price premiums. Acreage of specialty crops has recently increased in the United States; the share of IP corn rose from less than 3 percent of U.S. corn in 1995 to 7.2 percent in However, the extent of acreage devoted to differentiated crops varies widely, from over a million acres (food-grade corn, lowtemperature-dried (LTD) corn) to fewer than 100,000 acres (high-amylose corn, short-grain rice) (table 1). The number of specialty corn types is also expanding beyond the traditional niche markets for specialized animal feed. IP soybean acreage is hard to determine, but may range from 5 to 20 percent of total soybean acreage, depending on the extent to which sulfonylureatolerant soybeans (STS) are marketed as a specialty crop. Like corn, the number of specialty soybeans is growing, including food varieties (tofuclear hilum) for Asian markets, soyfood products, and non-gm soybeans. Wheat and rice produced and marketed as IP have also been developed. Table 1 Major specialty grains and oilseeds grown in the United States Product type Product name Acreage Marketing (x 1,000 acres) channels Output- Standard, with HES corn 150 (2003) Segregation specific special handling Food-grade corn 1,200-1,500 (2002) within bulk traits Low-temperature dried corn 1,200 (2001) Specialty type High-lysine corn 100 (2000) Segregation (nontransgenic) High-oil corn 500 (2002) within bulk Nutritionally dense corn 85 (2003) Waxy corn 700 (2003) White corn 900 (2002) Waxy wheat NA "Desert" durum wheat 264 (2003) Short-grain specialty rice 34.7 (2002) Waxy rice NA High-oleic high-oil corn 5 (2001) Closed loop Low-phytate corn NA High-amylose corn 60 (2003) High-sucrose soybeans 4.5 (2003) High-isoflavone soybeans 12 (2003) Low-saturate soybeans 11 (2003) Low-linolenic soybeans 2 (2003) Blue corn NA Contained/ Clear hilum tofu soybean 970 (1997) bag shipping Transgenic (GM) High-oleic soybean 10 (2002) Closed loop Absence of Non-GM corn (2002) Segregation attribute Non-GM/STS soybeans 14,000 (2003) within bulk (non-gm) Non-GM wheat NA Organic Nonconventional Organic corn 135 (2003) Certification production Organic soybeans 175 (2003) (ISO 65) 1 Pharmaceutical Not approved Pharma crops NA Closed loop/ and industrial for food/feed High erudic acid ("Crambe") 8.5 (2001) Containment NA = Not available. 1 ISO 65 = ISO Guide 65 points general requirements for organic certification bodies. Source: Various university and industry reports. 2

10 A number of forces affect the accelerated differentiation within grain markets. While these forces act principally at the intermediate levels of the supply chain (handling, processing and food manufacturing), consumer preferences are also at play. Consumers in industrialized countries, in response to dietary and health concerns, are more likely to demand variety- or attribute-specific grains. For example, the rising demand for low-carbohydrate food prompted greater interest in resistant starch (not easily digestible), hence offering much higher dietary fiber relative to carbohydrates. This starch, in turn, requires specialty grains that best meet specific starch requirements. Not all product attributes are readily discernible by final consumers. Credence goods, like foods derived from organic grains, require process verification. By contrast, products with search or experience attributes can be distinguished either visually (e.g., clear-hilum soybeans) or through testing (waxy corn, high-extractable-starch corn). Better testing and measurement technologies have enabled food manufacturers and retailers to discern and demand attribute-specific food products and ingredients. Global supply chains are adopting new standards of safety and conformity, partly to meet trading requirements (such as sanitary and phytosanitary standards), but more often to place their proprietary consumer goods into differentiated-product markets. Food processors demand for trait-specific crops derives from the need to improve production and processing efficiency, reduce costs, or enhance product value. General Mills, for example, now procures variety-specific wheat and oats, relying on contracts with a network of producers and cooperatives in several States. Warburtons, in the UK, has established contracts with Canadian wheat producers to deliver variety-specific wheat. Demand for specialty grains is reflected in buyers willingness to pay a premium over conventional grains (see box on next page). Processors pay a premium for specialty/differentiated grains due to their production efficiencies. For farmers, such premiums must be sufficient to offset any yield drag associated with specialty grain varieties, as well as any additional costs of production or segregation. Several supply-side forces also contribute to greater grain differentiation, including improved and novel varieties derived from biotechnology. To date, most biotech crops have involved agronomic traits (e.g., herbicide tolerance or resistance to pests). These crops do not require segregation in the U.S. marketing system, and no market premiums apply. However, consumer aversion to biotech in some markets can lead to premiums for nonbiotech grain, pushing retail chains and agricultural suppliers to separate biotech from nonbiotech products. The number of output-trait grains using biotechnology that have reached the market remains limited. One example is low-phytate corn, a genetically modified corn naturally high in digestible phosphorus. Hogs fed this corn excrete less phosphorus in manure, so low-phytate corn can reduce pollution from hog farms. There are several reasons for the limited number of output-trait grains from biotechnology. Much of the early effort focused on input traits, given the huge market for feed crops and expected return on investments. Concern about consumer acceptance and limited food use for some crops may have slowed the development of output-trait varieties. Nevertheless, many output-trait 3

11 Price Determination for Trait-Specific Crops Basic demand and supply for commodity and trait-specific crops is represented in the figure below. Supply and demand schedules for the generic commodity are denoted by S c and D c. The market clears at P c. Farm-level supply of the trait-specific crop is S v. Demand by processors (or other end-users) at the end of the marketing chain is D 1. Farm-level (derived) demand is D 2. The vertical distance between D 1 and D 2 (price P a minus price P b ) represents the extra cost of segregation and IP in the supply chain. Also, producers earn a premium given by P b minus P c. This model identifies the additional costs associated with trait-specific crops. The supply curve for the trait-specific crop lies above that for the generic commodity, owing to higher per-unit production costs. The vertical distance between supply curves S c and S v represents the extra farm-level costs for supplying a trait-specific crop, while the vertical distance between D 1 and D 2 represents identity preservation costs. Given inelastic demand for the trait-specific crop, small shifts in supply (S v ) can produce large changes in producer premiums. For a sufficiently large increase in supply, the producer premium can evaporate. Moreover, shifts in supply or demand in the commodity market also affect price premiums indirectly. Price determination for value-enhanced crops Price S v P a P b S c P c D 1 D c D 2 Quantity 4

12 products are in the pipeline, with entirely new crop uses, both in food and feed (e.g., high-oleic-acid soybeans, modified-starch corn, low-phytate corn). Biotechnology has also influenced grain markets indirectly by yielding products (e.g., enzymes) that increase demand for specialty grains. For example, development of new genetically engineered enzymes has expanded corn processing, enabling the corn wet-milling industry to produce starches tailored to specific industrial and food uses (Hicks et al., 2002). This, in turn, has increased demand for trait-specific corn types such as waxy and high-amylase corn. Also, corn fiber is being investigated as a source of biobased industrial products, nutraceuticals, functional food ingredients, and biofuels. The current push to use crops for biofuels production, particularly from cellulose, is likely to spur the development of genetically modified crops with desirable cellulose characteristics to facilitate more efficient cellulose-to-ethanol conversion. Innovations in transportation, logistics, and information technologies have also facilitated the marketing of differentiated grains. For example, Webbased bin-monitoring software can remotely assess the quantity and quality of grain inventories in a supplier s storage facilities. Communication networks and increased reliance on the Internet are also cutting transaction costs, especially for third-party authentication. Differentiation is expected to grow as commodity markets respond to new economic opportunities from high-value production. Nearly 70 percent of U.S. grain industry leaders forecast in 2002 that identity preservation would be important in 5 years (compared with 20 percent who thought it was important at the time of the survey). Likewise, 76 percent thought that diagnostic systems for quality attributes would be important in 5 years, compared with 31 percent at the time of the survey (Shipman, 2003). Overall, differentiated grain markets differ markedly from those for commodity grains, notably in market liquidity, price premiums, cost structure, the need for segregation, diversity of standards, and the nature of and approaches to risk management. These differentiated markets are characterized by identity preservation systems, with different implications for competition and market structure than commodity markets. Consequently, the policy implications and the public role may also be different from the government s traditional role in commodity markets. In this report, we examine the economics of grain differentiation the cost implications of different protocols, the unique risk factors of adopting IP grains, the use of contracts, and the role of government as a provider of market information and facilitator of product-differentiated markets. 5

13 Marketing Channels and Quality Assurance Grain product differentiation occurs both to preserve desirable traits in a crop variety (e.g., milling yield of wheat into flour) and to exclude traits perceived as undesirable by some users, such as GM content. Differentiated grains are further distinguished from commodity grains by market prices and underlying cost structures. An identity preservation (IP) system ensures that producers, handlers, and processors keep trait-specific grain separate from other grain types throughout the supply chain. IP crops fall into four broad categories based on production requirements, specialized marketing, and quality assurance schemes (table 2). Production Requirements and Marketing Channels Production requirements for IP crops vary from simply using a specific variety (trait-specific crops) to specialized production methods (organic crops), from protection against GM contamination (non-gm crop) to crops that require an elaborate set of safeguards and confinement practices (pharmaceutical and industrial crops). The production requirements for IP grains are influenced by such factors as the degree of purity required, the volume shipped, and market acceptability. Marketing channels for IP crops can be separated into several types (table 3). Segregation by Channeling Specialty corn and soybeans produced in large volumes are segregated by channeling, which uses the existing commodity marketing system with slight modifications. Segregation by channeling flows from farm to truck/rail to elevator. The effort to minimize commingling varies from simply running equipment empty before switching varieties to designating Table 2 Grain identity preservation system: Main features and product types Output- Absence Certified Pharmaceutical/ specific of attribute organic industrial traits (GM) (federally regulated) Example High-oil corn Non-GM corn Organic soybean Cystic fibrosis corn Production Specific variety IP production controls Certified organic seed IP protocols/isolation protocol Inspections Multistep inspections Dedicated equipment Field inspections Quality Testing Non-GM testing Non-GM testing 3rd-party audits assurance (Near reflectance) Auditing Auditing Certification Certification Certification (National Recordkeeping Organic Progam) Source verification Marketing Segregation Segregation Certification Closed loop/ channels within bulk within bulk containment 6

14 Table 3 Major marketing channels for indentity-preservation grains Marketing Channel Specialty Examples of channel features crop type IP crops Large volumes Standard corn/soybeans Yellow # 2 corn Bulk Blended for minimal quality Traditional soybeans Low cost/flexibility Separate sites/days/cleaning Enhanced value traits White corn, high-oil corn, Channeling Impurity threshold: 1-5% GM-free yellow food grade corn, waxy corn, non-gm corn IP controls extend to farm Trait-specific High-oleic soybeans Closed loop Direct transfer to end-user Limited-approval GM High-amylose corn Lower threshold: 1% Stacked GM corn Closed IP/direct end-user delivery Food grade Blue corn Container 20-foot container/bags Non-GM/low threshhold Tofu/clear hilum soybeans Lower threshold < 0.5% Certified Certification regulations Organic crops Organic corn & soybeans (ISO standards) IP practices in production, handling Seed production Organic tofu/clear hilum Inspections along supply chain Certified seed Segregation/ Confined production Industrial crops High-erudic acid rapeseed Isolation Spatial/temporal separation Pharmaceutical crops Anti-hepatitis" corn Zero tolerance for commingling certain days of the week or alternate sites for receiving and shipping these specialty crops. Crops handled by this method include white, waxy, yellow food-grade, high-oil, and non-gm corn; non-gm soybeans; and desert durum wheat (grown in the Southwest and valued for its quality attributes). Closed-Loop System A closed-loop system provides more controls than mere channeling, and better protects the value of a specialty crop such as high-sucrose soybeans, high-oleic soybeans, or high-amylose corn. Production occurs almost exclusively under a contract between the grower and end-user. Typically, these production contracts mandate delivery of all production to a specified location, and require midseason inspections and return of all unused seed to the seed company. Third-party auditors also verify that the system is in fact a closed loop and that all requirements have been adhered to throughout the system. Container-and-Bag Systems For very small quantities of an identity-preserved grain, the container-andbag system is an effective means of transporting and marketing. It has been used for several decades in the seed industry and in exporting tofu/clearhilum food-grade soybeans to Asian markets. With this system, 20-foot shipping containers are loaded and sealed on or near the farm where production occurs. This guarantees more stringent purity levels (< 0.5 percent of GM or foreign content) than with the closed-loop system. Specialty crops and seed marketed under the container-and-bag system are produced under 7

15 direct contracts with end-users who take full charge of handling and shipping from farm to delivery. These contracts and handling arrangements normally encompass testing and tolerance/certification requirements, carried out either by the end-user or a third-party agent. Quality Assurance The degree of quality assurance varies widely among IP products, ranging from a simple Near Infrared Reflectance (NIR) test at the point of entry into the supply chain to a highly regulated system of verification, certification, and assurances for products under full confinement. Whenever feasible, seed testing for specific attributes is essential for marketability of the IP product. Testing is one of the main vehicles for ensuring identity and quality of trait-specific grains and oilseeds. Sampling and testing procedures are often specified in production contracts. Testing for waxy corn types requires a single iodine-and-water test conducted by an elevator (buyer) at harvest. In many cases, a third party may also be involved in sampling/testing at selected stages along the supply chain. NIR tests have been widely used to test for protein and oil content in grains. Moreover, advances in measurement and computing, such as digital imaging (DI) techniques, are enabling tests of very small or even single-seed samples for specific variety identification. Developments in the IP grain market and the burgeoning quality certification systems may indirectly affect the marketing of commodities, requiring an adaptation of existing grades and standards. As IP grain markets expand and their production and infrastructure become more widespread, it is likely that the grain commodity system itself would be altered by placing greater emphasis on quality (facilitated by better measurement technologies). The current grading system, which relies primarily on tests for visual traits such as cleanliness or damage, may be expanded to recognize intrinsic quality of grains and oilseeds. When testing is not feasible (as for credence attributes), auditing, certification, and traceability systems may be needed (Dunahay, 1999). For example, organic crops rely exclusively on certification for ensuring product integrity. Organic producers are certified for observing production protocols that cover pesticides, fertilizers, cropping histories, and biotechnology. Their farms and fields are subject to inspection by certifying agencies, which are private businesses and government agencies accredited by the USDA National Organic Program (Greene and Kremen, 2003). An IP system may or may not include source verification or full traceability, defined here as the ability to track the product backward from the point of final sale to its point of production. Full traceability is often driven by food safety management. Traceability does not affect the quality of the product; hence, identity preservation and traceability are not synonymous (see report on traceability by Golan and colleagues, 2004). The IP system for grain does not guarantee a continuous chain of custody from the final loaf of bread on the supermarket shelf back to the farm or field where the grain was grown. Under IP, testing is common at all points of transfer to verify quality, 8

16 safety, or absence of GM event (attribute) or quality trait, but the specific grain origin (individual farmer) is lost. The current U.S. grain market does not observe full traceability of grains from field to shelf. Nevertheless, the regulatory environment is changing significantly. The U.S. Public Health Security and Bioterrorism Preparedness and Response Act of 2002, the European Union s traceability and labeling directives beginning in April 2004, and the Biosafety Protocol on Biodiversity starting in 2006 are all inducing agribusinesses, particularly those at the start of the supply chain such as grain elevators and grain warehouses, to track shipments and supplies more than before. These regulations are expected to require that food and feed manufacturers, processors, transporters, and importers keep records of the (immediately previous) source of food, feed, or ingredient being accepted; the transporter who delivered it; the next recipient of the firm s product; and the transporter delivering it to that recipient. For grain markets, this partial traceability approach can lead back to the food/feed ingredient supplier or a group of elevators/farmers in the event of a food recall (Farm Foundation, 2004). A fully traceable system, as exists in the seed industry, 1 can develop only if there are strong economic incentives, such as foreign buyers with specific food safety concerns who are willing to pay very high premiums. E-Commerce and Third-Party Services The use of IP protocols requires that critical steps in production, shipping, and processing be observed and documented and that transaction information be managed. As a result, databases including information-tracking software are critical. The Internet can lower transaction costs managed by third-party data service providers. 2 A number of Internet-based service organizations have emerged to help facilitate the marketing of specialty grains and oilseeds, including testing/certification, matching producers with customers, information tracking, and e-commerce services. 3 1 In seed production, individual lots of seeds are catalogued by variety for each stage from breeder to seed registration and certification. Involved parties, including growers and seed companies, keep all records of production, field inspections, inventories, transportation moves, cleaning, certification tags, etc., for a minimum of 3 years. Compliance is verified either by third-party auditors or by crop improvement personnel from seed companies. 2 Internet-based service providers record the performance of the critical steps and the results of the trait tests from remote producer, shipper, buyer, and laboratory locations. The Internet also provides a cheap way to process and save the recorded information and to make it immediately accessible to all market participants. 3 For example, Genetic ID, an Iowabased certification firm specializing in identity-preserved food and feed products, serves as go-between for grains and ingredient suppliers (such as Cargill, ADM, Kerry, or Cerestar) and food manufacturers and retailers (such as Sainsbury, Nestle, and Safeway). Genetic ID offers a proprietary package service CertID that includes testing, validation, inspection, documentation, and certification with a proprietary seal. Such services certify that shipments are non-gm, organic, or have specific traits, depending on the client. 9

17 Costs of Segregation Technological, processing, and logistical innovations have created opportunities for specialty products that command premium prices. But an identity preservation market is predicated on farmers willing to grow such products and handlers to market them to end-users at acceptable costs. To earn the IP premium, those involved must incur added segregation costs and bear the risks inherent in IP production and marketing. The cost structure for identity-preserved crops differs from that of commodity crops in two important ways: (1) the added costs of segregation and identity preservation in the grain supply chain; and (2) the costs to mitigate risks specific to IP grain markets, risks rising from the characteristics of differentiated-grain markets, and the specific requirements for production and marketing. Sources of Segregation Costs IP costs derive from the volume of grain handled, levels of purity required, handling infrastructure, and the extent of risk and risk sharing. The relative impact of these factors on IP costs also differs by the type of specialty grain, and can vary at each stage of the supply chain. Basic IP costs involve the physical separation of grain, including dedicated storage, handling, and transport of harvested products. The main sources of added costs over conventional varieties are seed (including technology fees) and special transportation, handling/drying, storage/segregation, and management. (Farm surveys show that these segregation costs differ widely among specialty grains.) For high-oil corn, the largest additional cost is seed, as proprietary seed commands a technology fee, while the ease of testing for oil level makes physical segregation unnecessary (Fulton et al., 2003). For waxy, white, or food-grade corn, IP costs are more substantial for physical segregation (transportation, handling and drying, and storage). For specialty soybeans like tofu or seed soybeans, the main additional costs are seed technology fees and transportation. 4 IP costs are also affected by whether verification claims are required. Testing or documentation requirements are particularly important for crops marketed as non-gm, which require additional steps to avoid accidental commingling on the farm. In practice, this means growing border fields and staggering harvests to avoid pollen drift and contamination from non-gm fields. In the long run, farmers who choose to produce differentiated grain must also incur fixed costs in buying storage bins and drying/harvesting equipment. Grain elevators typically store and mix grain of varied quality and grades, in response to market signals. Identity preservation and segregation preclude these practices. Additional costs derive from physical separation, including separate storage and identity verification. 5 Marketing costs of IP products 4 USDA s Agricultural Resource Management Survey (ARMS) for 2001 shows that the additional expenses of storage, segregation, and transportation are substantial for specialty corn, while cleaning of planters and combines is negligible. 5 For identity verification, the costs include processes to review and record details of delivered loads and supporting certification, and costs to validate claims about IP (Maltsbarger and Kalaitzandonakes, 2000). 10

18 include expenses associated with contract negotiation and the procurement of suitable grain or oilseeds from farmers. Hidden or opportunity costs for IP elevators include loss of margins from forgone opportunities and from underutilized storage capacity, which are significant for some elevators (Bullock et al., 2000; Qasmi et al., 2004). Maltsbarger and Kalaitzandonakes analyzed segregation options for high-oil corn at the elevator stage and broke out separation costs into coordination, logistical, and indirect categories. They found that the average IP cost varies widely with volume handled and that the relationship between IP cost and IP volume is determined mostly by the physical configuration of the storage facilities. Indirect costs account for over half the total segregation cost and are higher with larger volumes, highlighting the loss of efficiency and revenue to accommodate IP inflows. Other studies have examined the indirect costs of delayed deliveries and loss of flexibility in moving large volumes of grains during the peak harvest period. 6 Variation in Cost Factors The impact of volume marketed on IP costs depends on the grain-handling infrastructure. Elevators that are able to segregate most effectively have many bins of varying capacity, as well as multiple pits and elevator bucket legs; these features enable the elevator to dedicate units to specialty grain, reducing the likelihood of commingling (Herrman et al., 2002). The volume of IP grain within the infrastructure is significant in selecting the optimal segregation strategy, including whether to designate elevators as IP-only facilities. For grains and oilseeds in Indiana, low-volume flows make it cost effective to designate IP facilities only when the processor of the product is local (Vanderburg et al., 2003). In IP-dedicated plants, the increased transportation and handling costs (of getting more specialty grain from farther away) are more than offset by the elimination of segregation costs. 6 Herrman et al. (2002) report that delays associated with segregating wheat during harvest accounted for 15.8 to 27.5 percent of total segregation costs. The method of grain shipment also influences IP costs. Containerized IP shipments are becoming the preferred response to the growing demand for segregated specialty grain (Reichert and Vachal, 2000). While bulk systems (train/barge) have historically been a cheaper way to move grain because of economies of scale, containerized shipping reduces time in transit. This is particularly important to customers requesting just-in-time service. Other advantages include better inventory management along the supply chain and better matching of supply with demand (and hence lower seasonal price fluctuations). The tolerance level for impurities allowed in grain also affects IP costs. The higher the degree of purity required, the higher the cost to validate compliance (table 4), especially for non-gm grain (Giannakas and Kalaitzandonakes, 2005). Segregating grain into biotech and nonbiotech entails greater marketing risks than trait-specific grain such as high-oil corn. 7 Under generous threshold requirements (95 percent or higher product purity), segregation costs are manageable within the current handling infrastructure (Lin et al., 2000). At higher purity thresholds (99 percent or higher), production and marketing of specialty crops can add significantly to IP costs. 7 Oil content that is lower by 1 percent might reduce price premiums paid to high-oil corn producers; 1-percent biotech content in a non-gm grain shipment could cause rejection a much bigger penalty for noncompliance, particularly for exporters. 11

19 Table 4 Estimated costs of segregation at a grain-handling facility from previous studies Author(s) Commodity Year Volume handled (bu.) IP system Costs ($/bu.) Herrman, Wheat ,500/hr. (model A) 1 High-quality HRW Boland, and Heishmann 7,500/hr-10,000/hr (model B) 2 High-quality HRW Bender, Hill, Corn and 1998 n.a. High-oil corn 0.06 Wenzel, and soybeans STS soybeans 0.18 Hornbaker Good, Bender, Corn and 1999 n.a. Non-GM corn 0.01 and Hill soybeans Non-GM soybeans STS soybeans Smyth and Canola 1999 n.a. Non-GM canola 0.6 Phillips 3 (1% tolerance level) Maltsbarger and Corn ,000 to 500,000 High-oil corn Kalaitzandonakes during peak harvest Wilson and Wheat 2002 n.a. Non-GM wheat (5% tolerance) Dahl (1% tolerance) 1 Model A: the elevator is characterized by 1 drive, 1 elevator bucket leg, and 2 dump pits. 2 Model B: the elevator is characterized by 1 drive, 2 elevator bucket legs, and 2 dump pits. 3 Costs of segregation entail those from growers to those from either importers or domestic end-users. n.a. = Not available, Under a stricter tolerance level (99 percent or higher purity), the high risk of rejection induces greater testing costs. IP costs are incurred in both the commodity and IP systems when the IP product is either unapproved or unacceptable in some markets (i.e., Starlink corn variety approved for feed but not food in the United States). By contrast, fully acceptable IP products (i.e., GM crops approved in all types of uses and all markets) incur costs only in the IP system. The smaller the tolerance or acceptance of a product in a market, the greater will be the effort and cost to maintain perfect isolation. 12

20 Risk Management The IP cost structure is also contingent on managing risks inherent in IP markets. These risks can arise from pricing factors (price premiums, quality, and information), production contracts, longrun investments, and farmers management ability, which affects both yield performance and proficiency with contracts and relationships. The nature and scope of risk vary depending on the type of IP crop. These risks are examined for three categories of IP crops: trait-specific, non-gm, and pharmaceutical/industrial. Risks Associated With Trait-Specific Crops Farmers face several risks when they grow trait-specific grains. These fall under four broad categories: market, production, business, and financial risks (table 5). Market risk arises either from uncertainty in finding buyers or rejection of shipments if specific grain standards and characteristics are not met. Market-type risks include base price risk common with commodity crops and price premium risk specific to IP crops. Production risk includes both yield and quality risk. The quality risk may arise from inadvertent commingling of grains with different characteristics or from unfavorable weather. Deviation from pre-specified quality may result in lower premiums, discounts, or outright rejection by the buyer. Business risk includes possible contract default by producers or contractors, as well as potential liability for any problems that arise with the grain. Critical relationships may also be strained or broken under specialty grain production. Financial risk is associated with investment risks due to variability in returns and loss of the asset. Trait-specific grain production may include investment risk above that expected for traditional commodities due to specialized equipment or facilities. Long-term returns on these investments may be uncertain since production contracts are typically for a single year. If the producer loses the contract or if the economics of the product become less favorable, the returns on the investment may be reduced. Bard and colleagues (2003) ranked these risks using an Illinois farmer survey and found that the top three risks faced by IP producers are related to price premiums (39 percent of respondents), yield (25 percent), and quality (22 percent). The key factor that draws farmers into and out of specialty corn is the price premium. Farm surveys conducted by the U.S. Grains Council ( ) show a high degree of entry and exit into and out of specialty crop production each year (Stewart, 2003), as much as 30 percent in the case of corn (fig. 2). The decision to enter or exit the specialty grain market may be linked to yield performance (fig. 3). Exiting farms may be either poor production managers or have unsuitable land or growing conditions. The high degree of entry and exit mirrors the higher fluctuations of supply and demand in differentiated grain markets. 13

21 Table 5 Producer risk in specialty grain: A typology Risk Risk Risk common type category with commodity Definition Sources of risk Base price Market Yes Risk of lower-than-expected grain prices other than changes in expected market price premiums Price premium Market No Risk of a change in premium Risk in producing value-enhanced without a change in quality grain (VEG) in open market within the crop year Market access Market No Risk of not having a viable market for the crop Short run: for either a VEG crop not grown under contract or the overproduction of a VEG crop Long run: risk of VEG disappearing from market following specific investments Quality Production No Risk of an unexpected quality level in Chemical composition and test the grain that affects the grain s value weights; contamination risk (GMO) through discounts or reduced premiums Storage quality risk post-harvest; Risk of rejection from low quality measurement risk (testing) Yield Production Yes Risk of lower-than-expected production Weather conditions, variety, (different from yield drag) unknown yield drag, soil fertility, pest pressure, and timing of field operations Contract Business No Risk of contract default by producer/ Default during crop year from lack contractor of performance; termination of multiyear contract after 1 year; risk of nonpayment upon delivery Relationship Business No Risk of adversely affecting critical Losing access to landlord/lender, relationships with buyers, suppliers, supplies, technology, knowledge, or other resource providers (unique and markets to VEG; determined by contracts or outside contracts) Product liability Business No Risk that a producer will be liable Contamination with GMO or food for problems safety; with grain liability specified in contracts; GMO contamination in organic will prevent organic labeling Investment Financial No Risk associated with returns on a Variability in returns (annual long-term asset changes in costs and revenues); loss of the asset (fire, theft, natural disaster); uncertain long-term returns on investments Source: Bard et al. (2003). 14

22 Figure 2 Share of corn growers exiting specialty grain markets, Percent Source: U.S. Grain Council. Figure 3 Specialty corn yields for farmers who maintain versus those who exit value-enhanced corn (VEC) production, 2002 Percent of farmers Plans to grow VEC in 2002 Plans to exit VEC in White Waxy High oil Hard endosperm Source: U.S. Grain Council. Risks Specific to Non-GM and Organic Crops Non-GM crops are subject to the added risk of testing for purity, which could result in rejection of shipments. The risk level depends on the testing technology and the purity threshold required. The less accurate the testing or the higher the purity threshold, the greater the risk. 8 This is a greater risk than with trait-specific grains, which incur only price discounts for inferior quality. Buyers risk receiving non-gm crops accidentally commingled with GM varieties, and so specify testing/segregation methods through contract terms, test specifications, and penalties (Wilson et al., 2005). Organic grain producers face risk from accidental commingling with GM crops since organic regulations prohibit genetic modification. In addition, the threshold for purity in organic crops can be more stringent than for non- GM IP crops. These stringent private standards are common for exports to Europe or Japan, where some buyers may demand near-zero tolerance, 8 Testing for GM presence can be done through detection of proteins associated with transgenes, or detection of the transgene itself in DNA. The relative ease or complexity (and hence cost) of a test depends on the nature of the product (whole-grain, semi-processed, or processed) and the amount of target protein or DNA that can be detected. The higher the amount of protein and the more accurate the measurement technology, the lower the probability of falsepositive results. 15